What is a Municipal Bond?
Municipal Bonds (or “munis”) are debt issuances by city, county, and state government entities to fund capital projects such as universities, hospitals, and infrastructure (e.g. highways, roads, sewage).
- What is the definition of a municipal bond?
- What are the two major types of municipal bonds?
- What projects are municipal bonds used to fund typically?
- What are the tax-exempt benefits associated with municipal bonds?
Municipal Bonds Definition
Municipal bonds can be thought of as loans to local, county, or state governments to fund public projects such as parks, libraries, public transportation (e.g. highways, bridges, roads), and other related infrastructure.
By investing in a municipal bond, an investor is lending capital to the issuer in exchange for:
- Semi-Annual Interest Payments
- Return of the Original Principal at Maturity
The maturity date of a municipal bond tends to range around one to three years, but there are longer-term issuances with maturity dates lasting more than a decade.
Municipal Bonds Tax-Exempt Status
The unique benefit to investing in municipal bonds is that the interest on municipal bonds is exempt from federal income taxes (and potentially also exempt from state/local taxes if certain requirements are met).
For instance, being a resident of a certain city or state for a specified number of years could be a determining factor.
Municipal bonds appeal particularly to risk-averse bond investors that seek a steady source of income with the priority of capital preservation.
Despite the fact that municipal bonds are not backed by the federal government in the manner that treasury bills and treasury bonds are, they are still considered to carry a very low risk of default.
To summarize, the benefits of investing in municipal bonds consist of the following:
- Predictable Source of Income
- Lower Default Risk Compared to Corporate Bonds
- Opportunity to Invest Locally – i.e. Familiarity with Issuer/Projects Funded
- Tax Benefits
Types of Municipal Bonds: General Obligation vs Revenue Bonds
There are two major categories of municipal bonds:
- General Obligation (GO): Bonds backed by the “full faith and credit” and taxing power of the issuing jurisdiction (i.e. the local/state government).
- Revenue Bonds: Bonds backed by a specific revenue source (i.e. projects) such as highways
General obligation bonds are issued by states or cities and are NOT secured and backed by asset collateral – rather, GOs are backed by the creditworthiness of the issuer and taxing power of the jurisdiction.
While the issuers cannot print money like the federal government, they can tax residents to have enough to pay bondholders (and avoid defaulting).
By contrast, revenue bonds are NOT backed by the taxing power of the government.
Instead, revenue bonds are backed by the revenue generated by projects or other sources, most commonly highways (i.e. toll fees) and lease fees.
Certain revenue bonds are “non-recourse”, which means that if the underlying revenue source fails to produce revenue, the bondholders do not have a claim.
Municipal bond issuers can also raise capital on behalf of entities providing public services (e.g. non-profit universities, hospitals, medical institutions, public transportation, utilities, safety).
Here, the municipality is considered a “conduit” issuer, meaning that a different 3rd party is responsible for meeting the periodic interest and principal repayments.
In the event of default, the issuer – i.e. the local, county, or state government – is ordinarily not required to compensate the bondholders.